Strengthening Oversight of Broker-Dealers by Instituting a Framework to Prevent Another Madoff

Commissioner Luis A. Aguilar

The facts surrounding Bernie Madoff’s unprecedented fraud are well-known. Through a Ponzi scheme, he stole untold billions over decades.[2] What is not as well-appreciated is that during the vast majority of this time, he operated solely as a registered broker-dealer. This led to the inevitable conclusion that the regulatory framework for broker-dealer custody required urgent strengthening.

The U.S. Securities and Exchange Commission (“Commission” or “SEC”) has finally adopted amendments to strengthen the framework governing broker-dealer custody practices to prevent another Madoff. [3] The adoption of these amendments comes more than four and a half years after Madoff’s scheme came to light in December, 2008, and more than two years after they were proposed.[4] As a Commissioner, I have often been asked about steps the Commission has taken to prevent another Madoff, and it has concerned me that these issues have not been addressed.

For example, when the Commission adopted rules regarding investment adviser custody practices over three and a half years ago,[5] it was clear that it was not the Madoff fix. At the time, I highlighted the urgent need for the Commission to take steps to strengthen the framework governing the custody practices of broker-dealers.[6] Because Madoff was registered solely as a broker-dealer for most of the time he conducted his Ponzi scheme, the investment adviser custody rules would not have prevented much of the harm he caused. In addition, unlike broker-dealers and banks, investment advisers typically do not maintain physical custody of client assets.[7] Thus, while I supported the adoption of the investment adviser custody rules, it was clear that more was needed.

Accordingly I am pleased to support the adoption of the amendments regarding broker-dealer custody.[8] These amendments, in conjunction with the 2009 rules regarding the custody practices of investment advisers,[9] are designed to create a framework to ensure that investor assets are safely held. This framework is critical to cultivating early detection and to preventing the type of fraud Madoff perpetuated.

This framework has several components, of which I will highlight just a few:

First, broker-dealers that carry customer assets must file with the Commission a compliance report stating that they are in compliance with certain of the financial responsibility rules. The report must also certify that the broker-dealer has effective internal controls to ensure compliance with those rules.[10] This will enhance early detection of misappropriated or lost assets, and identify weaknesses in a broker-dealer’s internal controls that could jeopardize the safety of customer assets.

Second, broker-dealers must identify in the compliance report any instances of non-compliance with certain of the financial responsibility rules and any material weaknesses in their internal controls.[11] Importantly, the compliance report must be examined by independent public accountants registered with the Public Company Accounting Oversight Board (“PCAOB”).[12]

Of course, for these rules to be meaningful, it is important to highlight the roles played by accountants and broker-dealers in implementing these amendments. First, it will be critical for broker-dealers to promptly notify the Commission of non-compliance, as required under the rules.[13] Second, accountants must notify the Commission of a broker-dealer’s non-compliance if the broker-dealer is required but fails to do so, and accountants should enact measures to confirm that a broker-dealer has notified the Commission of such non-compliance.[14]

I also want to acknowledge the role of the PCAOB. Under the Dodd-Frank Act,[15] the PCAOB has oversight authority over the audits of broker-dealers and has the authority to establish an inspection program for auditors of broker-dealers. I note that the PCAOB is in the process of finalizing its standards for broker-dealer audits and its inspection program.[16] I encourage the PCAOB to act with appropriate haste. The PCAOB’s oversight will help to ensure that accountants diligently perform their duties in examining broker-dealers. This is critical to the implementation of the framework.

Finally, I note that the SEC’s rules regarding broker-dealer and accountant notification of non-compliance with certain of the financial responsibility rules still require such notification to be made by telegraph or facsimile transmissions.[17] I urge the staff to modernize the notification process to allow broker-dealers and their accountants to provide notification to the Commission using more modern electronic methods, such as emails, which would be both faster and cheaper.

In conclusion, I support these long-awaited amendments. To that end, I want to commend the staff’s efforts to address the weaknesses in the broker-dealer custody framework illustrated by the Madoff fraud.

[1] The views expressed in this statement are those of Commissioner Luis A. Aguilar and do not necessarily reflect the views of the SEC, other SEC Commissioners, or members of the staff.

[2] When he confessed to the fraud, Madoff estimated investor losses at approximately $50 billion. See, e.g., Bernard Madoff Confessed $50 Billion Fraud Before FBI Arrest, Bloomberg, December 12, 2008, available at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aYzclQY1HkVE. According to statements on the website of Irving H. Picard, the SIPA Trustee for the liquidation of Bernard L. Madoff Investment Securities LLC, investor losses are currently estimated at approximately $20 billion. See, e.g., A Message from the SIPA Trustee Irving Picard, available athttp://www.madofftrustee.com/trustee-message-02.html.

[3]See, Broker Dealer Reports, Release No. 34-70073 (July 30, 2013) which sets forth a new framework regarding the custody practices of broker-dealers and their compliance with the financial responsibility rules. The “financial responsibility rules” for broker-dealers are Exchange Act Rule 15c3-1, which governs net capital requirements for broker-dealers; Exchange Act Rule 15c3-3, which sets the requirements for custody of securities and for a special reserve account to protect investor funds; Exchange Act Rule 17a-13, which requires periodic counts of all securities held by a broker-dealer; and the rules of self-regulatory organizations requiring that broker-dealers provide quarterly account statements to customers. In addition, concurrently with the amendments addressing broker-dealer custody practices, the Commission is adopting additional amendments that strengthen the financial responsibility rules. See, Financial Responsibility Rules for Broker-Dealers, Release No. 34-70072 (July 30, 2013). These amendments were proposed in May, 2007 and are also long overdue. These amendments are designed to, among other things, require broker-dealers to more accurately calculate and report net capital, provide additional protection to customers regarding sweep programs, and ensure that broker-dealers can quickly access customer cash reserves by imposing certain limitations on where they can maintain customer reserve accounts.

[9]See,Custody of Funds or Securities of Clients by Investment Advisers, Release No. IA-2968 (Dec. 30, 2009). This rule requires registered investment advisers that have custody of client funds or securities to, among other things: undergo an annual surprise examination by an independent public accountant to verify client assets; have the qualified custodian maintaining client funds and securities send account statements directly to advisory clients; and unless client assets are maintained by an independent custodian, obtain or receive a report of the internal controls relating to the custody of those assets from an independent public accountant that is registered with and subject to regular inspection by the PCAOB.

[10]Broker Dealer Reports, Release No. 34-70073 (July 30, 2013). Specifically, the compliance report must state that: the broker-dealer has established and maintained internal controls and that those controls were effective during and at the end of the most recent fiscal year; the broker-dealer was in compliance with net capital and customer reserve requirements as of the end of the most recent fiscal year; and whether the information the broker-dealer used to state whether it was in compliance with these requirements was derived from the books and records of the broker-dealer.

[11]Id. Under the amendments, a material weakness would include deficiencies in internal control relating to non-compliance with net capital and customer reserve requirements, and non-compliance to a material extent with the remaining provisions of the financial responsibility rules.

[13]Id. at 101-08. Broker-dealer notification obligations are discussed in the release and in a note to paragraph (h) of Exchange Act Rule 17a-5.

[14]Id. at 104-05. As discussed in the release, by necessity, an accountant would have to have measures in place to determine whether, and if so when, the accountant received a notification required to be provided by a broker-dealer to the Commission. The accountant could decide not to rely solely on the receipt of a copy of the notification and take other steps to check whether the broker-dealer provided notice to the Commission. For example, an accountant could obtain a copy of a facsimile transmission from the broker-dealer to the Commission.

[16]Proposed Standards for Attestation Engagements Related to Broker and Dealer Compliance or Exemption Reports Required by the U.S. Securities and Exchange Commission, PCAOB Release No. 2011-004 (July 12, 2011), available at http://pcaobus.org/Rules/Rulemaking/Docket035/PCAOB_Release_2011-004.pdf; Temporary Rule for an Interim Program of Inspection Related to Audits of Brokers and Dealers, PCAOB Release No. 2011-001 (June 14, 2011).

[17]See, e.g., Exchange Act Rule 17a-11, which provides, among other things, that broker-dealers must notify the Commission and other securities regulators of their non-compliance with the net capital rule, and states that such “notice shall be given or transmitted by telegraphic notice or facsimile transmission.” 17 CFR 240.17a-11(g).